Seven ways to earn tax-free income

Summer is a good two months away, but some of us are already sweating. And for good reason. North Block has hinted at a higher tax for the rich and, perhaps, even an inheritance tax. Though the latter is not likely soon, the former is a distinct possibility.

What will you do if the finance minister decides to play Robin Hood with Budget 2013? Evading tax is illegal, but avoiding it is not. The income tax laws provide enough opportunities to the savvy investor to bring down his tax liability. However, this requires intricate knowledge of the tax rules.

"The options to earn tax-free income have either narrowed down considerably or disappeared in the past few years," says Neeru Ahuja, partner, Deloitte Haskins & Sells.

Even so, with the right professional guidance, you can legitimately avoid paying tax on the income earned on your investments.

1. Use indexation to nullify tax

High inflation has been a curse for investors in the past few years, but for some, it has been a boon. Tax rules allow investors to adjust the cost of an asset to inflation during the holding period. The taxpayer has the option to pay a 10% flat tax on the long-term capital gains or pay 20% after indexation.

Though the rate is higher, the high inflation has made indexation the better option in the past few years.

The taxpayers who have availed of this inflation indexation benefit have been able to reduce their tax to nil. In fact, if you invested in a debt fund or a debt-oriented MIP scheme three years ago and earned annualised returns of 10%, your tax liability would be zero (see table).

"We have aggressively used this provision in the tax laws for our clients during the past 3-4 years," says Delhi-based chartered accountant Surya Bhatia.

Not all investments are eligible for the indexation benefit. Only certain capital assets, including debt funds, FMPs, debt-oriented hybrid funds and gold ETFs, make the cut.

Stocks, equity funds and equityoriented hybrid schemes don't get this benefit as long-term gains from these are already tax-free. Bank deposits and bonds are also out. The interest on bank deposits is fully taxable at the normal rates.

This is why Bhavesh Shah (see picture) wants to shift from FDs to debt funds.

In the highest tax bracket, 30% tax pares the post-tax yield of his FDs to barely 6.5%.

A homemaker's work is never finished. From sending kids to school to shopping and managing the household, her day is fully packed. Now, add one more task to this long list—investing to earn tax-free money.

This is not as simple as it appears. If you gift money to your wife, there is no tax implication. However, if this money is invested, the taxman will club the earning with your income for the year.

The clubbing provision under Section 60 is meant to check tax evasion.

If you are taxed on the income, is there any point in investing in your wife's name? Yes, there is. The clubbing happens only at the first level of income.

If this money is reinvested and earns an income, it will be treated as your wife's, not yours. "The income from the reinvested income does not attract the clubbing provision," points out Sudhir Kaushik, chartered accountant and co-founder of tax filing portal Taxspanner.com.

Here's how you can make this rule work for you. Gift money to your wife and then get her to invest in any of the several tax-free investment options (see graphic).

The earning will be clubbed with your income, but since these investment options are tax-free, it won't push up your tax liability. Your wife can then reinvest that money, and this time, the income will not be clubbed.

There's another way to escape clubbing. Instead of gifting, give her a loan to buy property. Rental income from the property will be treated as her income as long as she pays you a nominal interest on the loan.

As mentioned earlier, if a parent invests in a minor child's name, the income is clubbed with that of the parent who earns more. In some cases, a minor child may have a personal income, such as a cash prize in a competition or payments for commercials and events. However, this is rare and mostly it's the parent who invests on behalf of the child. There is a small Rs 1,500 exemption per child per year for the income earned by such investments.